Guys, Here the portfolio up date with my Argentinean position. I am up by 19% in Pesos but the performance is lousy in USD. That said, if the pari passu saga comes out Ok for Argentina (see http://ftalphaville.ft.com/tag/pari-passu-saga/) I expect my bonds to soar by 25%. The position Below. Pars, Discounts and Euro-GDP Warrants I think are the most undervalued fixed income assets in Latin America.

I have been recommending one European Bank as an equity and fixed income investment since the year started. This bank is Spanish based Banco Santander (NYSE: SAN) and I think the bank still is a good long. I believe its huge cash dividend ($0.80 per share or +10%) has great chances of being sustainable and hence the shares constitute a fair income source. That said, when I recommended Santander, I also warned that I expected price volatility to be very high. Unfortunately, recent news in Cyprus tell me that price volatility in European related assets could be still higher than expected (even much higher). What should you do with your Santander Shares if you own any? I think you should stay put for now. Let’s take a look at what is happening in Europe and what might be the consequences that you could face as an investor in the banking sector.

Non-Sense Policy in a Mediterranean Island.

Again, European authorities have shown that they are unable to offer real solutions to the Euro area problems. Brussels came up with the worst possible idea to help solve Cyprus’s crisis: in exchange for a 10 billion Euro bail out from the European Union, Cyprus will have to impose a one-off tax over all deposits in the local banking system. At the same time, the banks where deposits are placed, would have to offer depositors a “free out of the money” call on the bank’s capital. Total non-sense.

The one-off tax will be 9.9% for all deposits over 100,000 Euros and 6.75% for all smaller deposits. According to Paul Krugman, who is against this one-off tax policy altogether, the tax has been imposed because Cyprus has an over-sized banking system given its condition as a money haven, especially for the assets of Russian wealthy investors. Krugman argues that a straight-forward bail out would have been seen as a rescue to Russian wealthy investors who have been avoiding taxes everywhere else. Then why is a tax collected on “small” deposits? The reasons I have read from smart people such as El-Erian (Pimco’s CEO) do not convince me at all. I simply believe this is another non-sense policy with dangerous implications. The tax, even if it was reformed to affect in a lesser way small depositors, is setting a very dangerous precedent. Italian, Portuguese or Spanish depositors could start retrieving their deposits from local banks triggering bank runs and putting pressure on the European Central Bank (ECB) to intervene. Its very tough to understand what European authorities are exactly aiming to achieve. The idea of waking up one day and have my savings reduced by 9.9% but with a “free out of the money” call on my bank’s capital was insane until last weekend. I guess authorities will come back to reason and, at the very least, forget about taxing small deposits. Time will say and I think all will develop within a few days.

Implications For Investors.

The word in English to define Europe’s crisis is “protracted” which means: extended, long, prolonged, lengthy, time-consuming, never-ending, drawn-out, interminable, spun out, dragged out, long-drawn-out, overlong. That said, I don’t think the ECB would let a bank run happen in any of the big troubled European economies: mainly Italy and Spain. Cyprus is unique in its own way: bank deposits run as high as 800% of the country’s GDP making the country tough to rescue. I think that, at the end, a higher one-off tax will be imposed on big deposits (above 100,000 Euros or even above 500,000 Euros) while no taxes are to be imposed on smaller deposits. The precedent would still be dangerous but the impact should be less socially unacceptable. Besides, I don’t see any of this happening in Italy or Spain. To begin with, banks in both those economies are not as big (relatively to GDP) as banks in Cyprus are. Moreover, after many painful write downs, Italian and Spanish banks are in much better shape than they were two years ago.

As a matter of fact, I think that if a big sell off on high quality banks were to happen, it might be time to buy. I am long Santander equities and I also own Senior bonds from Banco Bilbao Viscaya Argentaria (NYSE: BBVA) which is also a great bank to own but is not as diversified out from Spain as Santander is (besides, its cash dividend yield is “just” 5.4%). I am also considering to go long on the Italian banking champion Unicredit (NASDAQOTH: UNCFF). The Italian economy is in terrible condition but there is huge value in the country and Unicredit is trading at 2013 50% of tangible book value (against 130% for Santander and 120% for BBVA). Buffett always recommends to be greedy when others are fearful. Maybe its time to follow his piece of advice and start looking at Europe’s leading banks.

A few weeks ago, in my blog FixedIncomeNow, I made a post about how I expected current record low rates of interest to increase at some point in the near future. After all, the US economy is ameliorating at a steady peace and unemployment is starting to react to this growth. When rates go up, bond prices go down unless your bonds have a floating coupon. Since 2008 bonds with floating coupons – usually tied to the London Inter Bank Offer Rate (LIBOR) – have been the big losers of the fixed income world. Of course, as the FED funds rates went down from over 5% in 2007 to nearly 0% in 2009 (staying there until now), bonds with fixed coupons were the big winners and soared in price. Right now it might be the time to start moving out from fixed coupon instruments to floating ones. Instruments that reflect the price and performance of investment grade fixed coupon bonds will be the riskier assets.

Risky Assets.

Even if it sounds counter intuitive, a very well constructed fund like the iShares Investment Grade Corporate Bond ETF (NYSEMKT: LQD) will be a dangerous place to stay invested in. With a weighted average coupon of 5% and a weighted average maturity of 11.86 years, the current weighted average Yield To Maturity (YTM) is just 3%. As soon as rates start to go up, this ETF (and all its equivalents) will plunge accordingly. As simple as that. Even one of my favorite fixed income instruments, the iShares High Yield Corporate Bond ETF (NYSEMKT: HYG) shall be a very dangerous instrument to own. As a matter of fact, and even if it sounds very counter intuitive, this last ETF is going to be safer than its investment grade equivalent. The reason is simple, an improving economy will make the average rate of insolvency of US companies lower (making high yield bonds safer) and, at the same time, the weighted average maturity of the high yield instrument is significantly shorter at 4.3 years. Besides, the current weighted average price premium on the high yield ETF is not higher than that at its investment grade equivalent (the iShares High Yield Corporate Bond ETF has a weighted average coupon of 7.53% and a weighted average YTM of 5%). A good measure of yield to price risk is the bond’s duration. The higher the duration, the harder the bond’s price falls for every extra point in the bond’s YTM. Actually, the iShares Investment Grade Corporate Bond ETF’s weighted average duration is 7.69 years while the iShares High Yield Corporate Bond ETF’s effective duration is 3.91 years. The shorted the duration, the more protected you are as rates go up.

Fixed Income Safe Heavens.

As I mentioned at the beggining of the article, you should go for floating rates. iShares has a fairly good ETF that owns bonds whose coupon payments change based on prevailing short term interest rates. This fund, called the iShares Floating Rate Note ETF (NYSEMKT: FLOT), which has a very low weighted average coupon of 0.91% and a weighted average YTM of 0.61%, should outperform the market when rates go up but is not my favorite instrument to play the coming trend. After looking at many instruments, I could find one that I am seriously considering to buy: the Goldman Sachs Preferred Shares A Series (NYSE: GS-A). This shares will yield you 3 Month LIBOR + 75bp with 3.75% Dividend Floor. Trading at 91% of face value the current cash yield is around 4.3%. They pay 10th day of February, May, August, and November and they are perpetual shares. If you are looking for a floating rate instrument go long Goldman Sachs Preferred Shares A Series!